A survey of global equity markets

Regulators’ arbitrage

Markets are evolving faster than regulators

CAPITAL markets, including equity markets, are much like other markets, save perhaps for two characteristics: their speed and their regulation. They react all but instantaneously to changes in supply and demand, which is one reason why they can be so volatile. And both they and those who operate in them are overseen by a complicated mishmash of government rules and regulations, designed (at least purportedly) to protect investors. As the number of investors grows, this job assumes increasing significance.

As ever, America was the pioneer. The Securities and Exchange Commission was set up as long ago as 1934, with the legal remit of supervising and policing not just stock exchanges but all the public capital markets. Like all regulators, it operated with and through the established exchanges, especially the NYSE, which retained a large self-regulatory role. The SEC has formidable investigatory powers and can levy substantial fines for infringements of its rules. Indeed, the amounts it collects in fines typically far exceed its (relatively high) operating costs.

Yet although the SEC remains the model to which other countries aspire, it has not always found that the course of regulation runs smooth. Not the least of the problems in America has been the hotch-potch of different regulators for different bits of the financial-services industry, mainly for reasons of history rather than deliberate strategy. For instance, banks may be supervised by the Federal Reserve or the Office of the Comptroller of the Currency (part of the Treasury) as well as state bank regulators. Deposit insurance is handled by a separate agency. Anybody involved in the equity business also has the SEC breathing down their necks. The derivatives markets are mostly regulated by the Commodities and Futures Trading Commission (CFTC). As for insurance, it remains regulated almost entirely at state level.

This higgledy-piggledy structure may have suited a time when, thanks partly to such laws as the Glass-Steagall act, financial institutions generally engaged in only one activity. But the scrapping of Glass-Steagall and the arrival of universal banks on the European model have blown it apart. Many of America's big banks now have to deal with several different regulators, which significantly increases their compliance costs. Citigroup, the biggest financial institution in America, has to satisfy not just several but hundreds of different regulators, because it is active right across the country in banking, securities, derivatives and insurance.

The SEC's long-standing chairman during the Clinton administration, Arthur Levitt, eschewed battles over the structure of American regulation, although his organisation has long wanted to take over the CFTC. Instead, Mr Levitt focused his attention on a basic question: what is regulation for? His answer was to put protection of individual investors at the top of the SEC's priorities so as to encourage the country's equity culture. His weapons were tough enforcement, greater transparency, full disclosure and spirited attacks on conflicts of interest. That did not always make him popular with the professionals. Despite his own background in the equity business, for instance, Mr Levitt was no friend of the NYSE, which he saw as hogtied by its own special interests. He would much prefer it to demutualise and become a public company, perhaps shedding its regulatory responsibilities along the way.

Elsewhere, Mr Levitt did not always get what he wanted either. His struggle to stop the accounting firms from offering consulting services to audit clients, for example, ended rather limply in a requirement for disclosure rather than a ban. He similarly failed to push through accounting changes that would have required companies to take the full cost of stock options into their income statements. And one of his last acts, known as Regulation FD, which requires companies to disclose market-sensitive information to everybody in the market, preventing them from discreetly briefing analysts, remains highly unpopular on Wall Street. Mr Levitt had made it clear that he was worried about conflicts of interest within investment banks—and especially about the compromising of analysts' research by pressure from banks' mergers-and-acquisitions teams.

It is a pity that Mr Levitt made no attempt to sort out America's regulatory muddle, even so. True, he might not have been able to achieve much, if only because changes would require congressional approval, but at least he could have put the issue on the agenda. However, Phil Gramm, the Republican senator who chairs the Senate Banking Committee, and who had frequent clashes with Mr Levitt, rejects suggestions that America should adopt a single financial regulator. His principle, he says, is “first, do no harm”. He sees no reason to change a system that does a good job supporting the country's equity culture. But the problem is not so much that the American regulatory system has not worked; it is that it costs too much and that it may not be well-suited to international regulatory co-operation, at a time when capital markets are going global.

In other countries, the regulatory picture remains mixed. For many years, most of them relied largely on their stock exchanges to regulate their markets, which were anyway relatively small. The message for the individual investor, who was often regarded as more trouble than he was worth, was caveat emptor. Until recently, for instance, insider trading was not illegal in much of continental Europe. Accounting standards, provisions for disclosure, transparency requirements, takeover rules, the permissible treatment of minority shareholders: all varied hugely between markets. And the agencies in charge varied a lot, too: they might be the exchanges themselves, or government ministries, or sometimes central banks.

More recently, countries have been learning a good deal from each other, not least because a growing equity culture has brought so many new investors into the marketplace. In 1997, Britain scrapped the cumbersome regulatory structure set up after the 1986 Big Bang. This had involved a string of self-regulatory bodies placed beneath a Securities and Investments Board that was, in essence, a weakish version of the SEC. It was replaced by an independent Financial Services Authority designed to regulate not only the securities business but banks and insurance as well. The FSA's chairman, Sir Howard Davies, has become a keen advocate of the case for a single financial regulator—though he has also, generously, conceded that the British approach is only one among many.

Still, there is now a discernible trend in financial regulation towards the British model. Most countries are coming round to the view that central banks should not be the regulators of commercial banks, partly because it might distract them from their main function of setting monetary policy and partly because a banking scandal might damage their reputation. Sweden, Australia, Ireland and the Netherlands, among others, have recently gone down the British route of setting up an autonomous single regulator for the entire financial-services industry. Japan too has its own FSA, though since its boss is a member of the cabinet, doubts must linger about its true independence. Earlier this year, the German federal government announced its own plans to set up a single financial regulator, although the Bundesbank and the German states are stoutly resisting any efforts to reduce their role.

Twin peaks

Besides America, only France and Italy, among rich countries, still insist on a separate regulator for banks and for the securities business. Michel Prada, head of France's stockmarket regulator, the COB, believes strongly in a “twin peaks” approach, the banking commission of the Bank of France being the other peak. He says the two regulators have different, and sometimes conflicting, objectives: his concern is protection of the investor, whereas the Bank's concern is with prudential regulation. He suggests that a single regulator would be blamed for every trivial financial scandal, making it less effective. He also argues that a large agency might be formidably difficult to manage. Whereas the COB employs just over 200 people, Britain's FSA has over 2,000.

These differences of style might be mere curiosities but for one thing: the globalisation of both the capital markets and the equity investor. Because both investors and intermediaries (and, as we have seen, stock exchanges themselves) increasingly operate across borders, regulators must do so too. That throws differences in regulatory structure into much sharper relief.

The regulators have responded in several different ways, most directly by drawing up the Basle rules on minimum standards of capital adequacy. The idea was to set common rules for how much capital internationally active banks should set against their risk-adjusted assets. The rules were first introduced in 1988 and have been updated several times since, for example to add capital charges for market risks to those for credit risks. The latest revision has been sent out for final consultation, and is due to come into force in 2004.

The trouble with the Basle rules is that the weightings are crude, even misleading (for example, South Korea and Mexico are ranked with all other OECD countries for credit riskiness), which sometimes produces perverse effects. One beneficial effect, however, has been to encourage the growth of capital markets at the expense of bank financing. For firms operating in the securities business, there are no internationally agreed minimum capital standards, although most national regulators impose rules of their own (as does the EU, through its capital-adequacy directive). Efforts to negotiate Basle-like standards through IOSCO, the international body for securities regulators, have come to nothing.

Banks and securities firms have tended to trespass heavily on each others' territory, and most countries are now heading for a single financial regulator, so the differences in the treatment of banks and securities houses have become somewhat moot. But the Basle process also confers benefits in the shape of the constant exchange of information between bank regulators, which the capital markets miss out on, and for which they have tried to find substitutes. The past decade has seen a mushrooming of memoranda of understanding (MOUs) between regulators. But even MOUs may not be enough to cope with globalisation. How can the world manage, in the absence of a single, omniscient global regulator?

A Euro-SEC?

The problem is, inevitably, most acute inside the European Union, which is seeking to construct a single financial market even while retaining national regulators. So far, the results have been disappointing. Plenty of obstacles remain in the way of a true single financial market, especially at the retail level. For instance, several EU countries require their pension funds to invest largely in domestic government securities. In France, a recent tax break for equity investment was, extraordinarily, restricted to investment in French companies.

Earlier this year a committee of “wise men” under the chairmanship of Baron Alexandre Lamfalussy, a former head of the European Monetary Institute (the forerunner of the European Central Bank), issued a report on the regulation of European securities markets. The Lamfalussy report drew attention to the failure of the investment-services directive, passed in 1996, which was supposed to create a single securities market in the EU. It suggested a new streamlined legislative process that would revolve around the creation of a European regulators' committee and an EU securities committee, staffed by senior finance ministry officials. The Stockholm EU summit in March broadly endorsed the report.

Does this herald an EU-wide SEC? Mr Lamfalussy, an arch-federalist, says it might. But for the time being the appetite for any such body remains small. Although some continental bankers say that an EU-wide regulator would be a help, most fear that it would simply impose an additional layer of regulation, on top of the national ones. So long as legal systems and enforcement remain national and not supranational—which means, in effect, so long as there is no single EU government—the regulatory structure seems likely to remain largely national too.

A second reason for thinking that a Euro-SEC may be some way off is that, predictably, even the relatively mild Lamfalussy proposals are caught up in a typical power struggle between the European Commission, the Council of Ministers and the European Parliament. One senior regulator argues that the process of creating a single securities market in Europe would be smoother if the European institutions were kept out of it altogether.

And what about that bear market? It may well make regulators and governments busier, because more scandals and abuses tend to be uncovered when equity prices fall. A rising market, in contrast, disguises a variety of sins. Yet apart from that, there is no reason why regulators—or governments, for that matter—should have much of a stake in a bull as opposed to a bear market. Indeed, there is a strong argument against any such bias. One reason why the American bull market defied earlier efforts to talk it down was that investors persuaded themselves that the Fed would support equity prices by cutting interest rates as much as was necessary. Despite the markets' recent rally, the “Greenspan put”, as it was once christened, now seems to have been over-optimistic. In the long run, that can only be good for the world's equity culture.